Friday 17 August, 2018
Here in the Fixed Income team we are constantly on the lookout for the best risk adjusted returns we can find for our clients.
At times that may mean favouring the New Zealand bond market over international companies, or it could mean keeping a higher than normal proportion of your portfolio safely in cash to wait for a better day when returns meet our view of a company’s risk.
At other times it may mean allocating small proportion of a portfolio into high yield bonds to capture extra return through a very carefully risk-controlled process.
What is a high yield bond?
Corporate bonds fall into two broad categories expressed via their credit rating:
- Investment grade bonds (lower risk of credit default)
- High yield bonds (higher risk)
A company’s credit rating is driven fundamentally by the credit rating agency’s view of a company’s ability to pay interest on time and repay what it has borrowed when contractually required.
An investment grade rating indicates companies/sovereigns with a lower risk of credit default.
High yield bonds are defined as corporate bonds rated below investment grade by large rating agencies like Standard & Poor's (S&P). These bonds typically offer higher coupons and returns than investment grade bonds (hence the term "high yield.")
It is important to stress that for the most part these are still quality companies that either prefer the flexibility being a high yield issuer provides, are aiming to return to or achieve an investment grade rating or who were acquired and thus had more debt than is ordinary in their capital structure.
Four reasons to favour high yield bonds
1. Potential for capital appreciation
We often focus on “fallen angels” or “rising stars” – companies that were recently investment grade or may soon be upgraded through rapid improvements. Both types typically share a clear path to an investment grade rating and the potential for capital appreciation (or upward movement in the price of a bond) is apparent for both.
Other events that can push up the price of a bond include positive earnings reports, management changes, positive product developments, acquisitions, or market-related events.
Conversely, if an issuer’s financial health deteriorates, rating agencies may downgrade the bonds which can reduce their value.
2. Enhanced current income
High yield bonds typically offer significantly higher yields and enhanced returns than investment grade bonds, which provide for higher current income (the interest you receive for lending to a high yield issuer throughout the year) and a higher overall return upon repayment.
3. Relatively low duration
High yield bonds tend to have shorter maturities so are typically issued with terms of 10 years or less. They are often callable (the company can choose to repay the bond) after four or five years.
In a rising rate environment, high yield bonds would be expected to outperform many other fixed income classes.
High yield bonds typically have a low correlation to investment grade fixed income products, which allows for an element of portfolio diversification.
So, what are the risks?
High yield bonds are more volatile than investment grade bonds and carry a higher risk of default.
In times of economic stress, defaults may increase – making this asset class more sensitive to the economic outlook than other sectors of the bond market.
How does Kiwi Invest mitigate the risks
We tend to focus on companies that are at the higher end of the high yield credit rating spectrum (the BB level as per the above chart) and we conduct a great deal of analysis into how they operate including:
- Cash flows
- Market position
- Legal documentation
- Company structure
We also aim to diversify among high yield issuers and ensure that strict limits are in place for any one position.
As part of our diversified approach we recently added bonds issued by household names such as Hilton and bubble-wrap manufacturer, Sealed Air because they have defensive business models, a clear operating strategy and excellent cash flow generation to portfolios.
This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only.